Rebirth of Reason


Measuring Costs
by Joseph Rowlands

There are different ways of measuring costs. A business might measure costs in terms of the money expended in the process of production. Economists may talk about opportunity cost, pointing out that if picking an inferior option is a cost in itself since you could have done better. How are these costs measured? And what are they used for? It seems there are multiple purposes, and each is best satisfied by different methods.


One useful distinction is whether you are trying to estimate costs for a future decision, or whether you are trying to measure costs for a past decision.


If we look at future decisions, our information is very limited. We don't know exactly what the costs will be. We can estimate what we think each option will cost, as well as how much benefit we'll get. We can evaluate along two lines. We can determine whether any of the choices will be expected to produce a net profit, or we can determine which of the options produces the highest profit (or lowest loss).


Determining whether we expect a net gain or loss is useful only if we are evaluating a single option. But we aren't. If we have to make a decision, the useful evaluation is determining which of our options is beneficial. What if a business has no options that are expected to be profitable? Well one of the options is always to go out of business, or close shop for a period of time. When the full range of possibilities are compared, the choice should be based on which option is best.


So in this case, opportunity cost makes sense as a real kind of cost. If you don't pick the most profitable options, and instead pick something lesser, you choice is incurring an upfront cost. The difference in expected profit is like an added cost. The same effort will produce a lower result. In this kind of decision, it makes sense to choose the best option. So when looking forward to a decision, all of the options are compared and the best should be taken, with any lesser decision incurring an opportunity cost.


What happens when we look back on our choices? There are a few different ways of looking back, all of which are useful for different reasons.


A business may look back and determine whether its choice was actually profitable. It makes sense to determine whether your decision ended up being a good one. It is also useful to determine what your new position was. If you lost money, you want to know how much you lost. If you gained money, you want to know how much. So this comparison is simply a before and after comparison. There is no comparison with other options, so there is no use for the concept of opportunity cost.


A different reason to look back is to compare the options based on new information and decide whether your choices was useful. The original choice was based on certain predictions about the future. With new information, you can check to see if your original analysis was right or needed substantial modification.


Why reexamine the past like this? It's not a matter of blame or assigning fault. You made the decision based on the evidence you had available at the time, and can't be faulted for not knowing the future. But if there was a more optimal choice, you can determine what information would have allowed you to see it. Perhaps there was information available, but you didn't know about it. Or perhaps you had weighed some evidence as unimportant, and it had a significant impact. To learn from mistakes, or to learn how to improve decisions in the future, it is necessary to reevaluate past choices with new information.


All new information is worth examining. If one of your rejected options turned out to be the best, it is worth comparing them. If there were options you didn't even consider, perhaps you can figure out why you didn't and how you can avoid missing future options.


So if the goal is reexamining past choices, what kind of cost should be used? Each option can be compared against the previous estimate for that option. This isn't really measuring cost, though. It is measuring a difference in the outcome, whether positive or negative. But in a sense, it is measuring cost by absolute standards. It is the absolute difference between the expected and final profit that is important.


You could also try to determine which of your options would have been better to take. This isn't very useful, though. You don't have the ability to make the choice over, and there's no reason to regret a decision that was made with the best information you had. So while a comparison is possible, it isn't useful for learning from your past. To learn from the past, you want to know what information would have made your decisions more accurate.


The final reason to look back at previous choices is to check whether you utilized the information you had accurately at the time. This could be simply to confirm why you made the choice you made, or whether you made an avoidable error. This process is similar to the way future decisions are made, except that you ignore your current knowledge and try to only use the information you had at the time.


This suggests that opportunity costs are useful when making a decision, while absolute costs are useful in looking back and either learning from your past or in calculating the actual results in terms of profit or loss. It makes little sense to discuss opportunity cost for past choices. If you did, you'd almost certainly find "opportunities" that would have been more profitable, and so you'll always see your decision as being costly. But since you couldn't see the future, this kind of analysis is useless.

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